Does Volcker give the Fed too much credit?

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Paul Volcker’s speech to the Economic Club of NY last week (pdf) was generally reported as the latest example of the former Fed Chairman calling for more substantive financial system reform. He did repeat those points, but the focus of his speech was about the importance of the Fed maintaining its regulatory and supervisory authority over the banking system. At a certain point, this seems the stuff of absurdist theater. If the Fed never intends to use its regulatory authority, why insist the authority be maintained?

The problem with his speech is that while he acknowledges the Fed is badly staffed — mostly with economists/mathematicians, few from business/banking — he doesn’t address the clear failure on the part of the FOMC to 1) grapple with bubbles nor 2) to get serious about sensible reforms. He bemoans “reform light,” but that is precisely what the Fed is delivering.

Volcker wants tougher rules for derivatives trading, yet Pat Parkinson — the man Bernanke appointed as the Fed’s top bank regulator — has long favored a hands-off approach to derivatives. Volcker argues proprietary trading and other risky activities should be spun-off from commercial banks. It makes no sense for such risky activities to be backstopped by the financial system safety net — deposit insurance and last resort lending from the Fed. Yet Bernanke has done nothing to indicate he’ll separate the two.

Volcker is correct that the Fed should play a vital role in regulating the banking system. But this assumes the guys in charge actually use their regulatory power. Bernanke hasn’t done so. Instead he adopted his predecessor’s deregulatory zeal and penchant for bailing out the system.

Continuing the pattern of the last 25 years, the next financial market emergency is likely to be more disruptive than the last. The Fed has already lost so much credibility that when the next one hits, it’s not hard to envision it being neutered.